By Andrew Torchia

DUBAI (Reuters) - A plunge in Saudi Arabia's inflation rate, to its lowest level in more than 10 years, is good news for the kingdom's efforts to reduce a huge state budget deficit without stifling economic growth.

Annual consumer price inflation slowed to 1.7 percent in December from 2.3 percent in November, the Central Department of Statistics reported on Monday. On a month-on-month basis inflation was negative, with prices dropping 0.5 percent.

Much of the decline was due to lower food prices, which fell 4.3 percent from a year earlier. The desert kingdom imports many basic foods; its costs were reduced by soft global food prices and the Saudi riyal's peg to the U.S. dollar, which has been strong globally.

Riyadh hiked domestic fuel and utility prices in December 2015 to cut a $98 billion budget deficit produced by low oil prices. That caused inflation to almost double in the following month to 4.3 percent, its highest level since 2012, squeezing the incomes of Saudi consumers and slowing the economy further.

The leap in inflation threatened a political backlash which could have made the government more cautious about introducing additional austerity measures. The latest data suggests that threat has largely subsided.

"In the first half of last year, inflation caused a considerable erosion of household incomes and people's ability to pay for things - the data shows this has eased," said Jason Tuvey, Middle East analyst at London-based Capital Economics.

The data is also positive because it shows the economy has been flexible enough to absorb the fuel and utility price hikes of December 2015 without a self-sustaining spiral of higher inflation spreading into other sectors.

That is positive for the government because Riyadh plans another round of fuel and utility price rises around the middle of this year, after it has introduced a program to compensate poorer Saudis for the impact on their living standards.

The data does contain some areas of concern for Saudi policy makers, however.

Tuvey said it appeared inflation fell so sharply partly because Saudi companies were forced to slash their prices to compete as the economy weakened. A cash-strapped private sector may not be able to afford the new investments which the government wants to see creating jobs outside the oil sector.

Also, Riyadh plans to introduce a 5 percent value-added tax (VAT) next year to shrink its deficit further. While inflation could fall a little further early this year, it is likely to bounce back above 4.0 percent in response to VAT, Tuvey said.

(Reporting by Andrew Torchia; Editing by Gareth Jones)